Saturday, July 2, 2011

Iceland, Part I

We just got back after spending a week in Iceland. It is a country remarkable for it unusual geology, climate, people, history and -- unfortunately for Icelanders -- its economic difficulties.

Since this is a political blog I'll just give a brief summary of Iceland's features. It is an island just south of the arctic circle. This time of year it never gets dark: the sun sets around midnight and rises a few hours later, so there is just a brief period of twilight interrupting daylight hours. The population is only about 300,000, with at least 2/3 living in the capitol Reykjavik. The main industries are, usually, fishing, farming, renewable energy (mostly geothermal and hydroelectric), some manufacturing (aluminum and woolen goods) and, in the past dozen years or so, tourism. I say these are "usually" the principal industries because, during the fiscal "bubble" that briefly existed before the world-wide economic disaster of 2008, many Icelanders became preoccupied with amateur "investment banking". That is no longer considered a worthwhile or even socially acceptable activity -- nor is banking in general among Icelanders. The feeling is, in some sense, mutual, since there is no love lost between the international investment community and the populace and government of Iceland -- as I'll explain below.

Aside from the stark beauty of its topography, two factors are very important to understanding Iceland. The first is its placement as an island in the middle of some very rich fishing areas. Historically, fish and other maritime products have been the source of about 3/4 of Iceland's exports. In the '70s a virtual war with England over fishing rights broke out, and was only resolved by a NATO compromise -- mostly in favor of Iceland. Also, Iceland's claim of a 200 mile wide territorial fishing water has influenced its relations with both NATO and the European Economic Community.

The other factor important to Iceland is its volcanic activity. While this creates some problems -- e.g. the recent eruption of the volcano under Eyjafjallajokull ("jokull" means glacier), it also helps tourism ("Geysir", somewhat northeast of Rejkjavik, is the original geyser). Even more importantly, it is the source of an immense amount of cheap and renewable energy. Just about all of the hot water in Iceland, for example, is produced from subterranean streams of volcanically-heated water.

Geography and natural resources have, over the centuries, been instrumental in keeping Iceland self-sufficient and relatively isolated. Immigration has been so low that both the gene pool and the Icelandic language have remained quite stable for a thousand years. So has the fishing and farming basis of its economy.

Stable, that is, until somewhat less than a decade ago when the "financial services" industry in Iceland began to take off. In particular, until the Icelandic banks began a period of aggressive investment expansion. I have read a number of articles trying to explain what happened; here is my take. If you have further info, or a different view, please comment.

First of all, in the early 2000s, the Icelandic Krona was considered overvalued; it was trading at about 60 to the U.S. dollar. Second, the Icelandic central bank was willing to issue easy "liquidity loans" to its banks, and the world economy was booming. Finally, there was an additional source of low-interest capital available: foreign inverstors, principally Japan. Thus, the banks found this a very good time to start a long-term investment policy, where they anticipated very good rates of return. They financed these investments via short term loans. Thus, to keep the money flowing to the more profitable longer-term projects, the banks had to keep "turning over" or reinvesting their short-term interbank loans.

The von Mises Institute calls this kind of investment strategyMaturity Mismatching and points out its main danger: If the short-term investments can not be readily turned over, due to some impediment to liquidity (the ability to exchange assets or cash for assets), the banks can be left undercapitalized due to their long-term commitments. Furthermore, the artificially low rates established by the Central Bank of Iceland forced the banks, in order to compete, to issue riskier and risker mortgages (since they couldn't offer lower rates). Thus, though the derivatives business was not an important factor in Iceland, the banks still were involved in the equivalent of the subprime mortgage boom, and thus were vulnerable to the housing contraction that occurred in 2007-2008. Finally, the Central Bank explicitly committed itself to be the the "roller-over of last resort" for the banks, guaranteeing them short-term funds to protect their investments if it became necessary.

As the von Mises report states:

The ultimate problem with maturity mismatching is that there are insufficient savings available to finish the artificially high number of projects undertaken. Lenders have only saved for 3 months (i.e., the term of the commercial paper) or not saved at all (i.e., the term of the deposit), and not for 30 or 40 years (i.e., the term of the mortgage or capital project). Maturity mismatching deceives both investors and entrepreneurs about the available amount of real long-term savings. Hence, by borrowing short and lending long, long-term interest rates are artificially reduced. Entrepreneurs think that more long-term savings are available than really exist and accordingly engage in malinvestments that must be liquidated, once it becomes obvious that there are not enough real savings to sustain them to completion.

In the Icelandic case, the malinvestments were made mainly in the aluminum and construction industries. Both aluminum mines and residential and commercial housing represent long-term investment projects that were financed by short-term funds and not by savings of an equal term.

Meanwhile, the high rates of return that the Icelandic banks had been offering both domestically and internationally, had been so attractive that the entire financial services sector in Iceland was seeing an unprecedented national boom. Ordinary Icelanders who had been involved in the traditional Icelandic industries of fishing, farming and light manufacturing began to take up finance and investment with their private savings. For a period of several years investment banking was the fastest growing industry in Iceland, with billions of Kronor (plural of Krona) being diverted into speculation as opposed to direct financing of productive industry.

Within hours of the fall of Lehman Brothers, the Icelandic banking industry went under -- its source of short-term capital having dried up almost instantly. Within days the three largest Icelandic banks were in receivership and the entire economy seemed in imminent danger of complete bankruptcy, due to the commitments of the Central Bank. The government had to do something very quickly to avert total disaster.